Cents & Sensibility

Internet incubator E1 Media, the largest shareholder of Pacific Challenge Holdings Ltd, has failed in a blatant attempt to siphon HK$170m of cash out of PCH in return for a wildly over-valued Cents.com Ltd. In a rare success for minority shareholders, the deal was overturned. We look into the background and tell you how it happened...

Cents and Sensibility
11th July 2000

Pacific Challenge Holdings Ltd (PCH) was floated on the main board of the SEHK on 13-Oct-98, and in its short history has rarely had a dull moment. Before our main story, a little background.

History

PCH owned one of HK's smaller brokerages, Pacific Challenge Securities, and through Pacific Challenge Capital it also does a roaring trade in independent financial advisory opinions (the sort you see trotted out in connected transactions) as well as a range of other HK corporate finance business.

It was founded in late 1994 by Chairman Joseph Yu Shin Gay and Managing Director Brenda Lui Yee Man, with $100m of capital from 17 shareholders including "major corporations in the PRC, listed companies and high net worth private groups in Hong Kong, and Asian and European conglomerates". At the IPO, the only other executive director was Richard Hui Chung Yee, who is also a director of Central Development Group, controlled by Mr Hui Sai Fun.

The Oct-98 IPO of 59.72m shares was priced at HK$1.17 per share, raising $69.9m gross and $60.9m net. The offer represented 25% of the company, and no shares have been issued since then.

2 days prior to the IPO, PCH paid out a dividend of HK$74.65m to its pre-IPO shareholders, which was more than the IPO raised. Hence it was one of those floats that was done for reasons other than the funding requirements of the company.

Six months prior to the flotation, and in the wake of the 1997 crash, there had been a restructuring of the ownership. On 3-Feb-98 HK-listed Seapower Resources International Ltd sold its stake of some 21% back to the firm at the equivalent of $0.67 per share, for a total of $30.64m. The cost of this was met out of funds raised from management and other shareholders who put in $31.1m at an average of about $0.833 per share in Dec-97 and Feb-98 (but then got back half of it in the pre-IPO dividend, reducing the cost to $0.417).

Of this money, $2m was injected by Ms Lui and $11.6m by Mr Yu, while $16.9m was put up by a company called Roseville Consultant Ltd (Roseville). Although Brenda Lui, then MD of PCH, held the only voting share in Roseville, there were 168 non-voting shares and presumably each share cost HK$100,000. An investor believed to be Scandinavian and disclosed only as Kistefos A.S (Kistefos). held 50 of these shares and the investors who bought the other 118 shares in Roseville were not disclosed.

Kistefos was already a large shareholder, and apart from its interest through Roseville, it held 23.61% of PCH right after the float. It's quite remarkable that the prospectus divulged no further information on this largest shareholder of PCH.

The prospectus did, incidentally, contain a valuation of the Stock Exchange seats at just $4.5m each, which shows just how generous the Government has subsequently been with the merger terms of the SEHK.

Weak results

The market was in no mood for an opportunistic float. The issue was barely subscribed, and PCH shares fell 48% to $0.61 by the end of 1998. The group made an uninspiring profit of HK$31.0m in the year to 31-Mar-99, down 56% on the previous year, which of course included the red-chip bonanza and the Oct-97 crash. Trading volumes in the market collapsed in 1998.

The last published balance sheet, at 31-Mar-99, shows net assets of some HK$195m, including net current assets of $176m and shares in the stock and futures exchanges held at $15.5m. The group has no real estate. In the 6 months to 30-Sep-99 the group made an unaudited profit of $18.6m.

"For Sale"

On 16-Feb-00, during the heat of dot-mania, HK-listed Midland Realty (Holdings) Ltd said it was negotiating to buy less than 35% of PCH (avoiding the takeover trigger) from existing shareholders. The market expected PCH to be used as a listing vehicle for the estate agency's internet business. These talks were terminated 2 days later, but like any good estate agent, Midland had effectively planted a "For Sale" sign in PCH's front garden.

In fact, PCH was already in play. The shares had shot up earlier in the month, causing the Company to deny any knowledge of why this should be the case on 3-Feb-00 and again on 8-Feb-00 before finally admitting "preliminary negotiations" on 15-Feb-00 when the stock was suspended. By this time, the stock had risen 208% since the start of the month, to $2.40.

It then emerged that a second horse had entered the race for PCH. On 19-Feb-00, PCH announced that E1 Media Technology Ltd (E1 Media) had agreed to buy 67,934,000 shares totalling 28.4% of PCH, of which 15% was from Mr Yu, 8% from Ms Lui and 5% from Roseville. The price was $189.5m or about $2.79 per share of PCH.

As a result, when the deal was completed on 15-Mar-00, Mr Yu owned 1.34% of PCH and Ms Lui held no shares. E1 Media already held 3.73m shares in PCH, so the deal raised its holding to exactly 30%.

E1 Media

Privately-held E1 Media is an internet start-up incubator founded by Dr Lily Chiang (Dr Chiang), who is also an executive director and daughter of the founder of HK-listed injection moulding machinery maker Chen Hsong Holdings Ltd.

Dr Chiang owns 60% of E1 Media, while 20% is owned by Hikari Tsushin Partners II LP, 16% by Cable & Wireless HKT, 2% by HK-listed Online Credit International and 2% by PCH, which acquired its stake in Oct-99 for an undisclosed sum. C&W HKT's stake was announced on 18-Nov-99, followed by Hikari's investment announced on 22-Feb-00 and although the amount was not disclosed, Dr Chiang reportedly said the "investment was definitely more than $200m", reflecting a substantially higher valuation than earlier investors.

Cents.com Ltd

Finally we come to the punch. On 19-Feb-00 that E1 Media had "no concrete plan to inject any asset into [PCH]" and that "no such assets has (sic) been identified to date".

Sure enough, 2 months later, on 27-Apr-00 PCH announced (Word format) that Cents.com Ltd (Cents.com) was "identified by the Company recently" and guess what - it was 100% owned by E1 Media. It is always impressive how the best assets you can find are those owned by your largest shareholder. PCH proposed to spend HK$170m in cash to acquire 100% of Cents.com. That is almost the entire value of the net current assets of PCH at the last balance sheet date. It is also only $20m less than E1 Media paid for its stake in PCH in the first place, almost refunding the cost.

Non-cents.com

What is Cents.com? The first thing we tried was typing www.cents.com into our browser. Don't try this in front of the children - it comes up with a "domain for sale" page followed by a links page with links to various Yahoo! sites and some lurid pictures. Next we tried a whois search which gives a domain registrant in the Philippines. It seems fairly unlikely that Cents.com actually owns the cents.com domain. A quick trip to E1 Media's web-site failed to find Cents.com in any of their incubator projects.

Next, we tried the PCH shareholders' circular. At last, some facts! Well, sort of. The company was incorporated in the BVI on 5-Nov-99 and it provides a "modular type multi-lingual e-commerce platform for any business to engage in business-to-business commerce and services including procurement and online sales by catalogue and auction". We are then told "the real-time and interactive auction facilities provided by Cents.com are unique services". Unique? Haven't they heard of freemarkets.com, Alibaba.com and dozens of others?

Cents.com had net assets of $5,903,896 at 31-Mar-00, with profit since incorporation of $1,022,794. This implies an original investment capital of just HK$4.88m. They wanted to sell it for 35 times that, just six months after incorporation, The net assets include a loan of surplus capital to E1 Media in the amount of $6.7m. By the time the circular went out on 16-Jun-00 Cents.com had just 10 staff, of which 4 were in marketing.

Valuation without opinion

Chesterton Petty (take a bow) has valued the Cents.com business at $201.9m. However, their discounted cash flow (DCF) valuation, which attempts to assess the present value of future cash flow from the business, is not worth the paper it is written on, for the simple reason of the following paragraph in their letter:

In other words, the main role of the valuer was to whip out a calculator and discount the future cash flow without having any idea whether it could be achieved.

House of Cards

Next we turn to the Independent Financial Adviser, Asia Financial Capital Ltd (AFC). In the usual terms, they concluded that the deal was fair and reasonable and recommended the independent non-executive director to advise the independent shareholders to vote in favour of the deal.

Under the proposal, net tangible assets would shrink by 74% from $0.93 per share to $0.24 per share, and the vast majority of the cash would be removed. In their letter, AFC did not even mention this impact on net tangible assets and instead focused on management's assertion that the difference was all "goodwill" so that net assets (including goodwill) are unchanged.

On the subject of effect on earnings, AFC referred to the "revenue potential of Cents.com as reflected in its business valuation" and repeated an opinion of the directors that the deal "could bring an additional source of revenue to the group." Carefully chosen words; " revenue", not "earnings".

What we have here is a house of cards. The Independent Shareholders are advised by the Independent Director, who relies on the Independent Adviser, who in turn relies on the Independent Valuer, who relies on the projections made by the controlling shareholder, who is.... well, not exactly independent.

Sensibility

Thankfully, Independent Shareholders on this occasion ignored the advice of the independent director and voted with their brains. Sources tell Webb-site.com that HKSCC Nominees Ltd (HKSCC), representing public shareholders with shares in the clearing system, demanded a poll on the resolution in the meeting, so that each share counted, rather than just a show of hands (1 vote per person).

Luckily, one shareholder (probably Kistefos) had over 10% of the company, and instructed HKSCC to demand a poll. Unless you own 10%, the only other way is to get 3 registered shareholders to work together. That's not easy when most of the stock is held in the clearing system by HKSCC.

The holding of a poll on all votes is something that we have repeatedly said should be mandatory for listed companies, and the SEHK indeed proposed to do this (for connected transactions) in a May-99 consultation paper but has since failed to bring this into effect.

As a result of the poll, the deal was defeated. PCH gets to keep its money - for now at least. Until the next deal is "identified". We have seldom seen such a blatant attempt to extract such a large percentage of the funds of a listed company in return for so little.

A Mysterious Death

On 10-May-00, just 2 weeks after the announcement of the Cents.com acquisition, and having sold her shares in PCH in March for $52m, the body of Ms Lui was found floating off Deep Water Bay. Her clothing was found on a path linking Deep Water Bay with Ocean Park. A post-mortem showed the cause of death was drowning, and no wounds were found. The coroner's hearing has not yet been held, and it remains unclear what will happen to the ownership of the only voting share in Roseville, which she held.

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Cents and Sensibility 11th July 2000